Zaks Investment Advisory Service

Effects of Inflation on the Economy (Part II)

By tradition, I will begin the program with a review of last week’s events. The markets were relatively quiet and all the indexes gained about two percent. But will this be the calm before the storm? As all investors now probably know, on Tuesday, September 18, the Federal Open Market Committee will meet to discuss the financial state of our economy. Such meetings are held every six weeks, but I fail to recall when its outcome was last awaited with such anticipation. The Federal Open Market Committee (FOMC) is made up of seven members of the Federal Reserve board of governors and five presidents of its regional banks. These 12 people will decide the fate of our interest rates. Almost every observer expects a federal funds rate cut at the meeting. The question is only by how much – by 25 points (i.e. by ¼ of a percent) or 50 points (i.e. by ½ of a percent). At the end of the session, the FOMC will announce the new federal funds rate and release the meeting’s minutes. What the minutes say will come under even more investor scrutiny than the extent of the rates cut itself. If the results of the FOMC meeting disappoint, the market may suffer a fairly severe fall. Without doubt, the outcome will affect not only our markets, but all of the international ones as well.

In our previous program, we discussed how the Federal Reserve would have preferred not to reduce interest rates, since this could potentially lead to higher inflation. And inflation, even at relatively low levels, acts as an additional tax on the economy. I would like to note that at the moment, our overall economy is performing quite well, which is why the Federal Reserve is wavering about what to do about interest rates. If the economy had slowed down significantly, then the Federal Reserve would have lowered rates a long time ago, trying to give it a boost.

We also mentioned last time how one of the negative effects of inflation on the economy is that it forces people to try to get rid of their money. This leads to potentially productive resources being wasted on efforts to minimize the amounts of cash. On a scale of the entire economy, this seemingly insignificant response to inflation could result in large losses: up to one percent of the gross domestic product, according to some economist estimates.

Inflation negatively affects the economy in other ways, too. One of main problems is uncertainty about future price levels. Studies have shown that the higher the level of inflation, the more uncertainty there is about how it develops next. Companies and people do not have to read scientific tracts to know this – they sense it by intuition. This uncertainty leads to several unpleasant results. First of all, long-term interest rates grow. We have talked about how interest rates are made up of two components: one that compensates investors’ loss of purchasing power, and another that earns investors real returns. Well, investors with a poor understanding of where inflation levels will stand in a few years demand high compensation – just in case. As a result, companies that issue bonds are forced to spend additional resources. These are unproductive expenses, and they affect the economy as a whole.

Second of all, due to uncertainty about the level of inflation, companies prefer to strike short-term contracts and refuse long-term ones. This also affects the economy. And third, uncertainty about inflation’s growth rate creates price distortion: it becomes more difficult for both producers and consumers to tell whether prices went up because of actual shortages on particular goods, or as a result of inflation. As we know, in a market economy, producers use prices as signals to determine whether it is worth their while to invest in specific projects or not. When these signals begin to fail, the whole economy starts to malfunction as well.

And finally, one should not forget about another outcome of inflation: the redistribution of wealth between different age groups. We have already talked about how when inflation grows, the price of bonds falls. In relation to federal government bonds, this produces an unusual result. The government issues bonds to finance its activities. In the end, either directly or indirectly, the elderly end up holding most of the bonds. And inflation eats away a part of their value. On the other hand, a Treasury bond is a debt that the government owes, and it is financed with the help of taxes. If the price of the debt falls, that means its financing will require less taxes. The young, working part of the population pays proportionately more tax than the elderly. Thus, young people gain when inflation grows because they pay relatively smaller taxes, while the elderly lose, i.e. a part of the wealth is transferred from the elderly to the young.

We have described several aspects of how inflation affects the economy. Of course, the Federal Reserve is well aware of all these problems. And this is the reason by the Federal Reserve is in no hurry to lower the interest rates, despite all the calls coming from Wall Street and the housing construction industry. On Tuesday, we will learn how our central bank weighed all the pros and cons, as well as how the financial markets graded the central bank’s work.

With this, we will draw today’s program to a close. This was Sergey Zaks. Thank you for your attention and until next time.